Hiking interest rates aggressively, as the Federal Reserve has done over the past 14 months, not only fights inflation but also has long-term consequences for the economy’s output and growth potential. This is the conclusion of a paper set to be presented at the Federal Reserve’s annual conference in Jackson Hole, Wyoming.
The study, conducted by economics and finance professors Yurean Ma and Kaspar Zimmerman from the University of Chicago, suggests that monetary policy can impact the productive capacity of the economy in the long term. It argues that a slower pace of innovation, resulting from higher interest rates, can have lasting effects on economic growth.
According to the authors, a percentage point increase in interest rates could reduce economic output by 1% up to nine years later. Given that the Fed has raised its key interest rate by 5.25 percentage points since March 2022, the study suggests that this campaign could lead to a 5% reduction in output in the coming years.
While inflation is easing and economic and job growth remain strong, Fed officials are currently debating whether to raise rates again this year or maintain them to avoid a possible recession.
The study does not conclude that the Fed should refrain from raising rates to contain inflation. Instead, it suggests that increased government funding for innovation could offset the negative effects of rate increases.
Traditionally, economists believed that interest rate changes did not affect the economy’s long-term potential. However, recent research challenges this view. Higher interest rates make borrowing more expensive, reducing consumer and business demand for products and services. This can make it less profitable for companies to develop new offerings and innovations that increase efficiency and drive growth.
Rising interest rates can also lead to less favorable financial conditions, making it more expensive to take out loans for new ventures. Investors may choose to put their money in safe bonds that offer higher interest rates instead of taking risks on new ventures.
The study finds that a percentage point increase in interest rates can lead to a 1% to 3% reduction in research and development spending within one to three years. Venture capital investment falls by 25% in the same timeframe, and patents for new inventions decline by up to 9% within two to four years. This decline in innovation leads to a 1% drop in output five years later.
The current rate-hiking cycle, with the Fed raising its benchmark rate by more than 5 percentage points since March 2022, could have more pronounced effects. Venture capital investment has already fallen by about 30% annually since the hikes began, impacting all major sectors. However, investment in generative AI has rebounded due to Microsoft’s $10 billion investment in OpenAI.
The dropoff in patents affects both public and private companies, large and small. Large public firms may be driven more by softer customer demand than unfavorable financial conditions in their pullback of innovation.
The study also notes that Fed rate hikes do not always discourage innovation. In the late 1970s and early 1980s, when computers took off, inflation and interest rates were high. However, the technological developments during that period were so significant that the rate increases had only a marginal effect.
The authors do not suggest that the Fed should necessarily hold off on further rate increases or quickly cut rates. Instead, they propose that government programs could provide grants or subsidies to companies to boost innovation during times of economic struggle or rising interest rates.
What are the potential consequences of aggressive interest rate hikes on economic output and productivity in the long run
Their productivity and long-term growth potential.
The study highlights the importance of monetary policy in shaping the economy’s productive capacity. The authors argue that higher interest rates can result in a slower pace of innovation, which can have lasting effects on economic growth. They suggest that a percentage point increase in interest rates could lead to a 1% reduction in economic output up to nine years later.
Considering the Federal Reserve’s aggressive hike in interest rates by 5.25 percentage points since March 2022, the study predicts a potential 5% reduction in output in the coming years. This raises concerns for policymakers as they balance the need to curb inflation with the risk of dampening economic growth.
Despite these findings, the study does not propose that the Fed should refrain from raising rates to combat inflation. Instead, it emphasizes the importance of increased government funding for innovation to offset the negative effects of rate increases on productivity and growth.
Traditionally, economists believed that interest rate changes had little impact on the economy’s long-term potential. However, recent research challenges this view, highlighting the significant role that monetary policy plays in shaping economic outcomes. By making borrowing more expensive, higher interest rates can reduce consumer and business demand, making it less lucrative for companies to invest in new offerings and innovations that drive productivity and growth.
Overall, the study stresses the long-term consequences of aggressive interest rate hikes, cautioning policymakers to consider the potential impact on economic output and growth potential. It suggests that a balanced approach, combining efforts to contain inflation with targeted investments in innovation, could help to mitigate the negative effects of higher interest rates on the economy.
Interest rate hikes by the Federal Reserve can potentially slow down long-term economic growth, as higher borrowing costs could dampen consumer spending and business investment.
Additionally, higher interest rates could also lead to a decrease in housing market activity and a potential slowdown in the overall economy.